"2013 Insights: Regulatory"

January 2013 | Skadden's 2013 Insights |

Communications Law: The Relentless Pursuit of Broadband Competition

As the Obama administration enters its second term, the Federal Communications Commission (FCC or Commission) is one of many federal agencies likely to experience turnover at the highest levels. While current FCC Chairman Julius Genachowski has not yet announced his intention to depart, many analysts expect him to do so at some point in the coming year. A new FCC chair can be expected to set his or her own priorities, and may refocus the agency on media issues or other areas that have seen less attention in recent years. However, Genachowski has devoted his attention to increasing the availability of broadband and enhancing competition within the ranks of providers of both wireless and wireline broadband services. Consolidation among existing broadband providers and the creation of new providers will continue to occupy a substantial portion of the Commission’s time, even under new leadership. Moreover, existing initiatives designed to make more spectrum available to the public, including the auctions of federal and broadcast spectrum authorized by Congress in early 2012, will continue apace. The dearth of available wireless spectrum will make this newly commercialized spectrum a highly valuable commodity. As a result, the Commission can be expected to remain at the forefront of the ongoing battles over the consumer broadband market.

As consumer demand for both wireless and wireline broadband services continues its inexorable rise, providers are finding new ways to expand their service offerings. In particular, wireless providers are reshaping their industry with a series of acquisitions of wireless spectrum licenses and spectrum license holders. The Commission, in turn, has signaled that its primary goal in reviewing wireless and wireline transactions will be to foster competitiveness in the consumer broadband marketplace.

Despite the regulatory challenges that brought down the AT&T/T-Mobile merger in 2011, T-Mobile and Sprint responded over the past year with acquisitions of their own — competitor MetroPCS and Sprint’s remaining unowned stake in Clearwire, respectively. Government and public interest groups thus far have taken a more favorable stance toward both transactions, recognizing the value of enhanced competition from smaller operators. Meanwhile, the FCC has continued to open up spectrum in the satellite bands, recently granting Ancillary Terrestrial Component authorities to Dish for the creation of a terrestrial broadband network. The Commission also has not shied away from addressing broadband-related policy issues within only tangentially related regulatory decisions. Recently, the FCC altered the general guidelines that limit the amount of spectrum held by individual wireless providers (the “spectrum screen”) within a specific spectrum transaction approval. Going forward, the Commission likely will make spectrum resources available and approve the consolidation of existing providers when such transactions have the potential to bring new or newly enhanced competitors into the wireless broadband marketplace.

The FCC also has demonstrated a willingness to accept consolidation between wireline providers where that consolidation brings clear consumer benefits. During the first half of 2012, the FCC considered the proposed multibillion-dollar acquisition by Verizon of spectrum licenses held by a number of cable companies, as well as a series of ancillary agreements through which, among other provisions, Verizon would resell cable broadband services. While the Commission ultimately approved the transaction, it also conditioned its approval on an agreement by Verizon not to resell cable broadband in any areas served by its FiOS fiber-optic broadband service. This approval confirmed both the FCC’s interest in making unused wireless spectrum available to the public and its continuing concern about the lack of competition in consumer wireline broadband.

The Middle Class Tax Relief and Job Creation Act: Spectrum Auctions and the Public Safety Network

On February 22, 2012, President Obama signed into law the Middle Class Tax Relief and Job Creation Act of 2012 (the Spectrum Act), which contained two major communications-related initiatives. First, to promote private sector spectrum use, the Spectrum Act requires the FCC to use new incentive auction authority to determine the prices at which participating TV broadcast licensees would be interested in relinquishing some or all of their spectrum rights, and then to use the Commission’s existing auction authority to reallocate that spectrum to other users through a traditional forward auction. The Commission has stated that over the next year it expects to issue a series of rulemakings requesting public input on the design of both auctions and that it hopes to conduct the auctions in 2014. In addition, a number of related provisions require the FCC to conduct auctions over the next three years to commercialize several specified blocks of spectrum currently allocated for federal use. Given the continuing increase in the market value of wireless spectrum, spectrum license holders, especially broadcast licensees, should carefully monitor these auctions and the possibility of future incentive auctions going forward.

Second, the Spectrum Act also lays the groundwork for the creation of FirstNet, the authority responsible for establishing a new public safety wireless broadband network (the Network) to support the efforts of first responders nationwide. In addition, the Spectrum Act offers $7 billion in federal funding to support the creation of the Network. However, it remains unclear whether the funding (and the associated spectrum dedicated to the Network by the Spectrum Act) will be used to build out independent wireless communications infrastructure or to support a FirstNet partnership with existing commercial providers to build out the Network. While FirstNet will operate under the auspices of the National Telecommunications and Information Administration, the Network itself will be built pursuant to FCC minimum technical guidelines and roaming rules. Private sector wireless network operators and municipal governments with existing public safety networks should pay close attention to the work of FirstNet, the FCC and other related agencies in the near term, as they set rules governing those networks’ interoperation with the Network and eligibility for federal funding.

Network Security Threats and Cybersecurity Legislation and Regulation

Network security incidents, including attacks both simple (e.g., distributed denial of service (DDOS)) and sophisticated (e.g., advanced persistent threats), caused significant damage and loss at a range of companies in 2012. The frequency of such cyberattacks has skyrocketed, resulting in severe business disruptions and losses of valuable intellectual property, personally identifiable information and sensitive national security information. In an October 2012 speech to business executives in New York City, U.S. Secretary of Defense Leon E. Panetta emphasized the “unprecedented scale and speed” of recent cyberattacks, including those on major U.S. financial institutions, and expressed grave concern at the prospect of a “cyber Pearl Harbor.” For his part, FBI Director Robert S. Mueller stated in March 2012 that, “in the not too distant future,” he expects the “cyberthreat” to surpass terrorism as “the greatest threat to our country.” Director of National Intelligence James R. Clapper has sounded a similar alarm, observing that “we face a cyber environment where emerging technologies are developed and implemented faster than governments can keep pace.”

Network Security: Corporate Risk Factor

An easy mistake is to view network security risks as concentrated on national intelligence and defense information or private suppliers of critical infrastructure, such as electric and water companies, telecommunications providers, public transportation systems and hospitals. In fact, such risks extend much further and confront companies from Wall Street to Main Street — and everywhere between:

In the U.S., several major banks have faced high-volume DDOS attacks that obstructed their ability to serve customers online.

In Europe and the Middle East, a new generation of tenacious malware aimed at acquiring information about financial transactions and private communications was uncovered by network security researchers last summer.

Last July, General Keith Alexander, director of the National Security Agency, put the total annual losses to U.S. companies from network security incidents, including losses of information and intellectual property, at an astonishing estimated $338 billion — or, as he put it, the “greatest transfer of wealth in history.”

Cybersecurity is an increasingly important factor in a company’s business and legal risk profile. As a result, in-house counsel continue to play an enhanced role in assessing risks, reviewing network security, evaluating disclosure considerations and developing policies to address concerns. Areas of responsibility include, but are not limited to:

The increasing prominence of network security threats has led to calls for action in Washington. At the end of 2011, it appeared that cybersecurity was one of the few congressional priorities without a fixed partisan valence and that the push for network security enhancement was likely to result in legislation. In 2012, both the House and the Senate proposed bills that contemplated new safeguards and exceptions to existing data privacy laws for businesses that share cybersecurity threat information with the government. In addition, the Senate bill asked the Department of Homeland Security (DHS) and regulatory agencies to work together to craft network security regulations that would be applied to critical private sector infrastructure operators. The House cybersecurity bill passed in April, and the Senate bill was brought to a floor vote in August and again in November. Today, however, action on both the Senate and House bills has stalled because of strong opposition from the business community and the White House, respectively.

After the Senate bill failed to win cloture in August, the White House signaled its intention to proceed with an executive order in the absence of legislation. Early drafts of that executive order indicate that the final order will include provisions to enhance the regulation of critical infrastructure. Under the most recent draft, which became public late in November, DHS would be required to identify critical infrastructure and create incentives to encourage entities that operate critical infrastructure to voluntarily comply with a security framework authored by the National Institute of Standards and Technology (NIST) in order to reduce cybersecurity risks. Meanwhile, agencies with responsibility for regulating critical infrastructure would be asked to provide reports to the White House detailing their respective authorities to regulate private sector entities’ cybersecurity. If existing regulations are deemed insufficient, those agencies would be further requested to propose “actions” to mitigate cyber risk. Separately, the order would attempt to create incentives for critical infrastructure network operators to share more cybersecurity information with the federal government, whose agencies would promise to protect that shared information to the extent possible under existing law.

Given the increasing emphasis on regulatory solutions to network security problems in the executive branch, several independent regulatory agencies already have begun laying the groundwork for addressing network security practices. In October 2011, for example, the SEC issued CF Disclosure Guidance Topic No. 2, which asked registrants to report cyber risks and incidents. Last year, it followed up on that guidance, sending letters to several companies requesting that they disclose their status as cyberattack targets in future SEC filings. In September 2012, the Federal Energy Regulatory Commission announced its intent to create an Office of Energy Infrastructure Security to step up regulatory oversight of potential cyber and physical security risks to energy facilities under its jurisdiction. New requirements to disclose cybersecurity incident information to regulatory agencies will correspondingly increase litigation risk. Both federal securities law class actions alleging failures to disclose and those based on disclosed information are likely to become increasingly common. The decision whether to disclose or not disclose cybersecurity risks and incidents needs to be carefully considered.

Agencies likely will continue to draft guidance and, in some cases, regulations to address perceived vulnerabilities in network security in regulated industries. While existing information technology regulation focuses heavily on data security — i.e., the protection of sensitive data, such as consumers’ personally identifiable information — going forward, information technology regulation also can be expected to have a heightened focus on network security practices and policies. As a result, the aforementioned risk factors requiring corporate counsel attention may become additional regulatory compliance concerns.

Private sector network operators in critical infrastructure industries likely will be prioritized as regulatory targets. While the definition of “critical infrastructure” remains the subject of debate, organizations in the energy, financial services, defense, transportation, telecommunications and public health sectors likely will see increased regulatory attention.

What to Expect in 2013

If progress on cybersecurity legislation continues to falter, an executive order may be handed down in the first half of 2013, which would accelerate executive branch agencies’ work on network security regulation. Agencies can be expected to offer several opportunities for regulated private sector entities to provide input into the regulatory process, including informal consultation with the government and formal notice-and-comment rulemaking.

Separately, in-house counsel will continue to navigate the complex issues surrounding corporate disclosures of cyber risks and incidents and the sharing of cybersecurity incident information with appropriate government agencies when faced with a serious breach. Given that an executive order will have limited power to streamline the sharing process, companies will need to weigh many competing considerations — including when and how to report a breach and to whom. In the absence of a legislative carve-out, various laws and regulations will need to be considered when disclosing information. Existing data privacy laws, including the Electronic Communications Privacy Act, can require heightened legal process before certain communications content information is disclosed. Considering these potentially significant implications, companies should engage knowledgeable counsel as part of assessing whether to exchange cybersecurity incident communications traffic and related logs with government officials.

Electric Power Generation: EPA Regulatory Developments

More so than regulatory developments, inexpensive natural gas may be the most significant factor limiting the development of new coal-fired power plants and the dispatch of existing coal-fired plants. That said, environmental regulations will continue to play an important role in shaping the future of electrical generation. Of particular importance is the United States Environmental Protection Agency’s (EPA) proposed rule that, for all intents and purposes, prohibits the construction of new coal-fired generation, absent a willingness to invest in relatively untested carbon capture and sequestration technology. Although unlikely, it also is possible that legislation could be passed in the next Congress that would impact one or more of the following regulatory developments (e.g., legislation that could preempt EPA’s ability to regulate coal combustion residuals in favor of the states).

Clean Air Act

Cross-State Air Pollution Rule. EPA has again struck out in its efforts to promulgate an allowance-based regulation to reduce the interstate transport of sulfur dioxide and nitrogen oxides. In July 2011, EPA issued the Cross-State Air Pollution Rule (CSAPR),1 which was the agency’s response to the U.S. Court of Appeals for the D.C. Circuit’s 2008 ruling remanding the Clean Air Interstate Rule (CAIR). In August 2012, the D.C. Circuit vacated CSAPR in a 2-1 decision. See EME Homer City Generation, L.P. v. Environmental Protection Agency, 696 F.3d 7 (D.C. Cir. 2012). The court held that under the Clean Air Act (CAA), EPA could not require states to reduce emissions (1) by more than their “significant contribution” to downwind air quality concerns or (2) by more than their “fair share” relative to the contributions of other states. The court ruled that EPA, having used air quality modeling to define what a “significant contribution” was for purposes of deciding which states would be subject to an emissions reduction requirement, ignored the results of such modeling when establishing emissions caps. In the court’s view, this meant that EPA was requiring some states to shoulder more than their fair share of the burden for reducing the impact of interstate air pollution.

The court also held that states did not have an obligation to prepare their own implementation plans (SIPs) to reduce interstate air pollution until EPA had determined (for each state) the amount of emission reductions that would be required. As a result, EPA did not have a legal basis to issue federal implementation plans (i.e., directly applicable federal regulations that EPA is required to promulgate after it finds that a state has failed to develop a state implementation plan) for each state subject to CSAPR when CSAPR was finalized.

As a result, the less stringent and less comprehensive (in terms of states covered by the rule) Clean Air Interstate Rule will remain in effect for the foreseeable future, subject to the outcome of EPA’s petition to the D.C. Circuit for a rehearing en banc or possible petition for certiorari to the Supreme Court if EPA’s petition for a rehearing is not successful. If EPA is not successful, it will have to go back to square one to determine how it will implement the CAA provision requiring states to eliminate air emissions that contribute significantly to downwind air quality problems. The decision in EME Homer City Generation may further limit EPA’s ability to develop creative air emissions trading programs to reduce air pollution under the existing confines of the Clean Air Act.

Hazardous Air Pollutants. EPA Administrator Lisa Jackson signed a final rule on December 16, 2011, limiting emissions of hazardous air pollutants (HAPs) from existing and new coal- and oil-fired electrical generating units (EGUs) (the Mercury and Air Toxics rule, or MATS).2

The MATS rule applies to those EGUs capable of combusting more than 73 megawatt-electric (MWe) heat input. For coal-fired EGUs, the regulation establishes numerical emission limits for mercury, particulate matter (as a surrogate for toxic non-mercury metals) and hydrochloric acid (as a surrogate for toxic acid gases), although the rule also provides alternative standards for certain subcategories (for example, limits on SO2 as an alternate to hydrochloric acid). For oil-fired EGUs, the regulation establishes numerical limits on total metals, hydrogen chloride and hydrogen fluoride. The final regulation relies on work practice standards, rather than numerical emission limits, to control the emission of organic acid gases such as dioxin/furan and to control emissions during start-up and shutdown. The rule also allows for emissions averaging among existing electrical generating units at a facility so long as the units are classified in the same subcategory. More stringent standards are established under the rule for new sources.

The MATS rule is subject to pending legal challenges filed by utilities, states and environmental groups. The utility petitioners argue that EPA’s determination in 2000 that it was “appropriate and necessary” to regulate HAPs from EGUs was flawed both procedurally and substantively. In particular, the utility petitioners argue that the record compiled by EPA does not support EPA’s findings that mercury, nonmetallic HAP metals and acid gas HAPs emitted by EGUs pose public health hazards; that EPA disregarded prior interpretations that it could only regulate those HAPs emitted by EGUs that were found to be a hazard to public health rather than all HAPs emitted by EGUs; and that EPA incorrectly determined that it was required to apply the stringent Section 112(d) “maximum achievable control technology” standard rather than more flexible alternatives. The utility petitioners further challenge specific aspects of the regulation as being substantively or procedurally defective.

In response to petitions filed by developers of proposed new EGUs, EPA proposed revisions to its regulation on November 30, 2012. Among the proposed revisions was an increase in the mercury emissions limit for high BTU coal-fired units to reflect practical issues associated with the monitoring of such emissions. EPA has stated that it intends to finalize these revisions by March 2013, an important milestone for project developers due to EPA’s proposed New Source Performance Standards (NSPS) for greenhouse gas emissions for such units.

Greenhouse Gas (GHG) New Source Performance Standards/Permitting. On April 13, 2012, EPA published its proposed NSPS establishing carbon dioxide (CO2) emissions limits from fossil fuel-fired EGUs pursuant to Section 111 of the Clean Air Act.3 EPA’s proposal combines fossil fuel-fired electric utility steam generating units (including boilers and integrated gasification combined-cycle units) and combined-cycle stationary gas turbines4 into one source category and requires new sources in this category to meet an output-based emissions standard of 1,000 pounds of CO2 per megawatt-hour (MWh), based on a rolling 12-month average. The standard is based on EPA’s determination that the “best system of emission reduction” that has been adequately demonstrated is new natural gas-fired combined-cycled (NGCC) turbines.

EPA’s proposed standard does not require the construction of NGCC units, although its analysis is based in part on the projection that between now and 2020, new coal-fired electrical generating units will not be constructed primarily because of technological developments and discoveries that have driven down the price of natural gas. EPA nonetheless has proposed a compliance alternative for new coal-fired or petroleum coke-fired power plants, if such plants are designed to include the construction and operation of carbon capture and storage (CCS) or equivalent systems. Such power plants will be in compliance if their emissions of CO2 do not exceed 1,800 lb/MWh on a rolling 12-month average basis for the first 10 years of operation; beginning in the 11th year, such plants must meet an emission standard of 600 lb/MWh for each 12-month period, so that over a 30-year period, the coal- or petroleum coke-fired plant will achieve compliance with the 1,000 lb/MWh standard.

The proposed regulation only applies to new sources; it does not apply to modified, reconstructed sources or existing sources. EPA also has stated that it does not have any intention in the next few years to propose emissions guidelines for existing EGUs pursuant to Section 111(d) of the Clean Air Act, although it will be under significant pressure from the environmental community to do so once EPA finalizes the NSPS.

The regulation also excludes proposed coal-fired electrical generating stations that have been issued major source air construction permits as of April 13, 2012, so long as construction begins on these stations by April 13, 2013.5 Because the developers of these plants (which are not designed to meet the proposed GHG emission limit) have substantial concerns about their ability to comply with the new source MATS limits, these developers are pushing EPA to revise the MATS rule for new plants so that they can obtain financing and commence construction prior to the April 2013 deadline.

On the permitting front, the D.C. Circuit upheld EPA regulations that subject new or modified sources of GHG air emissions to the Prevention of Significant Deterioration (PSD) preconstruction permit program, but substantially increased the emissions thresholds that trigger an obligation to obtain a PSD permit. In particular, the D.C. Circuit held that EPA’s determination that emissions of GHGs endanger public health and welfare was supported by the administrative record and that the petitioners challenging EPA’s decision to substantially increase the thresholds triggering a PSD permit did not have standing to sue because they had not suffered an injury that could be remedied by a ruling in their favor. See Coalition for Responsible Regulation v. EPA, 684 F.3d 102 (D.C. Cir. 2012). Petitions for a rehearing en banc were denied. Coalition for Responsible Regulation v. EPA, Nos. 09-1322 (D.C. Cir. Dec. 20, 2012).

Ozone and Particulate Matter National Ambient Air Quality Standards. An important driver of more stringent air quality regulations (including regulations such as CSAPR and CAIR) are national ambient air quality standards (NAAQS) for “criteria” pollutants, including in particular ozone and fine particulate matter. State implementation plans are required to demonstrate how they will achieve or maintain compliance with these standards. Moreover, as standards become stricter, more areas will be considered out of compliance with such standards; as a result, owners and operators of major emission sources must comply with more stringent requirements to construct or modify their plants, including obtaining emissions offsets to ensure that the construction or modification of a plant will improve air quality by reducing emissions overall.

In 2008, EPA lowered the eight-hour primary and secondary ozone NAAQS from 80 parts per billion (ppb) (eight-hour average) to 75 ppb, notwithstanding that EPA’s Clean Air Scientific Advisory Committee (CASAC) recommended a standard of between 60 and 70 ppb. In 2011, the Obama administration vetoed EPA’s proposal to lower the ozone NAAQS to 70 ppb because the ozone standard is subject to statutory review again in 2013. EPA has been sued by environmental groups as a result of this decision. CASAC’s initial policy assessment for the 2013 review has concluded that there is strong scientific justification for an ozone NAAQS between 60 and 70 ppb and there could be evidence supporting lowering the NAAQS to between 50 and 60 ppb. EPA anticipates finalizing a new ozone NAAQS in 2014.

The current primary and secondary NAAQS for PM2.56 are 15 micrograms per cubic meter (annual average) (established in 1997) and 35 micrograms per cubic meter (24-hour average) (established in 2006). In June 2012, as part of its review of this standard and in response to litigation over the 2006 rulemaking, EPA proposed to retain the 24-hour average and to lower the annual PM2.5 standard to between 12 and 13 micrograms per cubic meter (while taking comment on a standard as low as 11 micrograms per cubic meter).7 Pursuant to a consent decree, EPA Administrator Jackson signed a final rule on December 14, 2012, that lowered the annual PM2.5 NAAQS to 12 micrograms per cubic meter.

Clean Water Act

Cooling Water Intake Structures. In March 2011, EPA issued its proposed rule regulating cooling water intake structures (CWIS) for existing electrical generating and manufacturing facilities.8 EPA was to have finalized the rule in 2012, but has reached agreement with environmental groups to extend the date to sign a final rule to June 27, 2013. In 2012, EPA issued a notice of data availability seeking comments on alternative methods for minimizing “impingement” of aquatic organisms that would provide even more flexibility than allowed by the 2011 proposed rule.9

Effluent Limitations Guidelines. EPA continues to work on revising its technology-based limitations for pollutant discharges from steam electrical generating units, last revised in 1982. The updated regulations are expected to address, among other things, wastewater pollutants arising from the operation of ash ponds and flue gas desulfurization air pollution controls, the use of which are expected to expand as a result of the air pollution control regulations discussed above. As a result of modifications to EPA’s consent decree with the Sierra Club and Defenders of Wildlife (the most recent of which was submitted to the D.C. Circuit on December 10, 2012), EPA must propose regulations by April 19, 2013, and complete action on the regulations by May 22, 2014.

Resource Conservation and Recovery Act

Coal Combustion Residuals. EPA issued a proposal in May 2010 to regulate coal combustion residuals (CCR) generated by the combustion of coal at electrical generating facilities.10 EPA is still evaluating data and comments received on this rule proposal and subsequent notices of data availability and has stated that it does not contemplate finalizing a rule until 2014, although it also is fending off efforts by environmental groups and coal ash recyclers to obtain a court-ordered deadline for issuing final regulations.

Although most regulation of oil and natural gas exploration and production is conducted at the state level,11 the federal government is becoming more active in this area, especially with respect to the controversial (in some circles) subject of “hydraulic fracturing.” Hydraulic fracturing is a procedure to create fractures in rock formations by injecting fracturing fluids (primarily water with other additives depending on the formula used by drillers) and “proppants” (typically sand) to maintain fracture openings. This procedure allows the development of oil and natural gas resources in unconventional geologic formations.

Significant federal developments include:

Studies

EPA continues to work on a long-term study required by Congress of the potential impacts of hydraulic fracturing on drinking water resources. The study is looking at the “life-cycle” impacts of hydraulic fracturing, including the impact of large-volume water withdrawals on ground and surface waters; surface spills of hydraulic fracturing fluids, flow-back and produced waters; the injection and fracturing process; and the disposal of hydraulic fracturing wastewaters (including inadequate treatment of such wastewaters by public and private treatment works). A progress report on this study was released in December 2012 and a draft report purportedly will be released for peer review and public comment in late 2014. The study likely will impact the development of federal legislation and regulation of hydraulic fracturing and also may impact activities in the states. For example, legislation has been introduced in New Jersey to extend the moratorium on hydraulic fracturing in that state pending the results of this study.

EPA is investigating whether hydraulic fracturing in gas production wells in the area of Pavillion, Wyo., is impacting groundwater. In December 2011, EPA issued a draft report concluding that surface pits that had been used for the storage of drilling wastes and produced and flow-back waters are a source of shallow groundwater contamination in the area. EPA also tentatively concluded that impacts to deeper water zones could be explained by hydraulic fracturing, although EPA also noted that it had not conclusively demonstrated a causal link between hydraulic fracturing and contamination in the Pavillion gas field. EPA recently extended the public comment period on the draft report to January 15, 2013.

New Source Performance Standard — Green Completions

On April 17, 2012, EPA released a final rule for the oil and natural gas sector that included standards applicable to new wells that are completed after hydraulic fracturing and existing wells that are completed after refracturing.12 Beginning on October 15, 2012, the effective date of the rule, all such wells must route flowback during the flowback period to a completion combustion device, such as a pit flare. Beginning on January 1, 2015, such wells (excluding exploratory, delineation or low-pressure wells) must use “reduced emissions completion” technology to separate flowback liquids from gases and route recovered liquids into a well; route recovered gases into a flow line or collection line or use the recovered gas as an on-site fuel source, with no direct release of the gas into the atmosphere; and, for gas that is not salable, direct such gas to the completion combustion device. Petitions for reconsideration of the rule have been filed with EPA and petitions challenging the rule have been filed in the D.C. Circuit. Most of the industry concerns have more to do with other aspects of the NSPS (and related hazardous air pollutant regulation promulgated by EPA) than the reduced emission completion requirement, although objections have been noted over the interim control requirements. Environmental groups have expressed their objection to the rule’s failure to regulate methane emissions directly and the delay in imposing the reduced emission completion requirement until 2015.

Safe Drinking Water Act — Regulation of Underground Injection

Historically, EPA has considered hydraulic fracturing to be oil and gas production and outside the scope of its authority to regulate underground injection of fluids pursuant to the Safe Drinking Water Act (SDWA). This interpretation was called into question in Legal Environmental Assistance Found. v. United States Environmental Protection Agency, 118 F.3d 1467 (11th Cir. 1997). In the Energy Policy Act of 2005, Congress amended the SDWA to provide that underground injection (subject to the act) does not include fluids or propping agents (other than diesel fuels) used in hydraulic fracturing operations related to oil, gas or geothermal operations. In 2010, EPA posted a statement on its website that hydraulic fracturing operations using diesel fuel as an additive are regulated under the underground injection control (UIC) program. Given EPA’s historical inactivity, its 2010 statement, unsurprisingly, led to a legal challenge from developers asserting that this was a policy change that could not be implemented without an opportunity for the public to comment.

On May 4, 2012, EPA released a document titled “Permitting Guidance for Oil and Gas Hydraulic Fracturing Activities Using Diesel Fuels-Draft — Underground Injection Control Program Guidance #84.” In this guidance, EPA reaffirmed its position that the use of diesel fuel, either as a carrier fluid or an additive, as part of a fluid being injected for purpose of hydraulic fracturing for oil and gas production, is prohibited unless a UIC permit is issued. EPA further confirmed its view that wells used for hydraulic fracturing that are subject to the UIC program (because of the use of diesel fuel) should be subject to regulation as a Class II injection well (wells associated with oil and gas production). The draft guidance addresses a number of technical issues, including how diesel fuel should be defined, permit duration, well closure requirements, application requirements, well construction requirements, mechanical integrity, monitoring and enforcement requirements, and financial assurance. The public comment period on the draft permitting guidance closed on August 23, 2012.

Bureau of Land Management Proposed Regulations

On May 4, 2012, the U.S. Department of Interior, Bureau of Land Management (BLM), released proposed regulations governing hydraulic fracturing on federal and tribal lands.13 BLM’s proposed regulations would supplement (and in some cases duplicate) existing state and tribal regulations. The proposed regulation sets forth requirements for applications to conduct well stimulation, mechanical integrity testing, monitoring during well stimulation, storage of recovered fluids and information to be submitted after completion of well stimulation, including information on the volume of fluids used and the additives used in the well stimulation process. The BLM proposal generated much concern from industry and tribes about the necessity of the rule, given state and tribal regulation and potential costs, while environmental groups have asserted that the proposed rule does not go far enough to protect sensitive resources. The public comment period on the proposed rule closed on September 10, 2012.

Toxic Substances Control Act

In response to a petition by Earthjustice and other citizens groups, EPA in November 2011 declared that it would initiate a rulemaking under Section 8 of the Toxic Substances Control Act (TSCA) to require manufacturers and processors to submit data to EPA with respect to the substances and chemical mixtures used in hydraulic fracturing. Such data could include the quantity of substances manufactured or processed for uses, information on byproducts resulting from the use of chemicals and mixtures, estimates on the number of people exposed to such chemicals and mixtures, and data on health and environmental effects associated with such chemicals. Concerns have been raised by the oil and gas industry because of the potential breadth of the submittal requirements as well as the likelihood that many of the chemical additives used in hydraulic fracturing already have been subject to health and environmental effects submissions under TSCA or other environmental laws. EPA has not yet released a proposed rule under TSCA.

Government Affairs and Government Procurement Compliance

Corporations and other organizations engaged in government affairs or government procurement activities face laws regulating contributions, lobbying activities, conflicts of interest, gifts and related matters at the federal, state and local levels. Ensuring compliance with these laws will continue to be a challenge in 2013 for every industry. In addition, transparency in corporate political spending continues to garner attention in the boardrooms of the nation’s largest corporations.

Inaugural and Transition Activities

2013 is notable for the special legal issues that arise from making contributions to the inaugural or transition committees or paying for inaugural events or transition-related activities. Contributions to state or local inaugural committees may be subject to restrictions under state or local ethics/election laws, and federal or state pay-to-play laws. Inauguration-related events may include inaugural balls, as well as breakfasts and luncheons celebrating the inauguration or related to viewing the inauguration and the inaugural parade. To the extent such events involve government officials or employees, a company must ensure compliance with applicable gift and entertainment laws. Contributions to state or local transition committees may be subject to state or local ethics/election laws, and federal, state or local pay-to-play laws. To the extent a corporate executive serves on a state or local transition team (such as for a governor-elect), he or she may, depending on the jurisdiction, be treated as a public official and subject to that state’s or locality’s conflict-of-interest law. Moreover, use of corporate resources, or volunteering during working hours, may result in an in-kind contribution to that committee. It also is important to be mindful of ethics disclosures and conflicts issues for incoming members of the legislative and executive branches at the federal, state and local levels.

Developments on Disclosure for Nonprofits Engaged in Advocacy

As a byproduct of the landmark Citizens United v. Federal Election Commission decision in 2010, nonprofits such as 501(c)(4)s and trade associations are under increasing scrutiny by state regulators with regard to disclosure of the sources of their independent expenditures, which are funds spent on communications advocating the election or defeat of a candidate, without coordinating with any campaign or committee. States including California, Idaho and Montana have been particularly aggressive toward that end. At the federal level, it is possible the IRS may take public action toward some of these nonprofits. It is somewhat less likely the Federal Election Commission or Congress will take action. Nevertheless, corporations should continue to monitor these issues as disclosure of certain contributions may ultimately become required, particularly at the state level.

Lobbying Laws and Restrictions on Placement Agents and Increased Enforcement

An increasing number of states and localities are enacting laws classifying certain activities of investment advisers and placement agents as requiring lobbyist registration and reporting. California, New York state and New York City have been particularly active toward that end. The regulatory environment with regard to lobbyist registration and reporting laws also is tightening, especially for government procurement activity. More restrictive laws are being passed with regard to gifts and entertainment of public officials and employees. Enforcement cases are being pursued for entertainment costs as small as $12.

Ongoing Issues: Pay-to-Play Laws, Shareholder Activism

Increasingly restrictive pay-to-play laws continue to emerge at the federal, state and local levels as a reaction to various scandals involving public officials. Promulgated in 2010, the SEC’s Pay-to-Play Rule 206(4)-5 continues to present challenges for companies by way of implementation. CFTC Rule 23.451 imposing pay-to-play restrictions on swap dealers took effect on December 31, 2012. At the same time, additional federal pay-to-play rules are on the horizon, including SEC Proposed Rule 15Fh-6 and MSRB Proposed Rule G-42. At the state and local levels, new and amended pay-to-play laws continue to emerge with activity in Connecticut, Philadelphia and Los Angeles.

We continue to see an increase in activity by the Center for Political Accountability and other groups regarding transparency in corporate political spending and lobbying activities. Such inquiries have increased, as has shareholder activism, as a result of the Supreme Court’s decision in Citizens United. The timing and transparency of lobbying and political expenditure disclosure raises significant political and public relations issues with a corporation’s investors and competitors and the public at large.

Implementing Compliance Programs

Because of the increased risk of enforcement action as well as negative media attention in the event of a violation of law, an increasing number of corporations continue to develop and refine compliance programs to address the areas of law discussed above. There are common elements among these programs, including practical policies and procedures; pre-clearance of certain contributions, gifts and/or lobbying activities; protocols to ensure registration and reporting requirements are fulfilled; training programs for key officers and employees; and protocols for updates on the latest developments in this area of law.

The Supreme Court’s decision narrowly upholding the core provisions of the Affordable Care Act (ACA) paves the way for continued implementation of the law, including health insurance market reforms, new employer coverage mandates, reforms in Medicare payment and reimbursement, and new taxes on drug and device manufacturers.

However, the landmark ruling also has created a significant degree of uncertainty. The Court held that the act’s Medicaid expansion violates Congress’ spending authority: Capitol Hill cannot cut a state’s entire Medicaid funding (as opposed to the incremental funds provided in the act) if the state chooses not to implement the expansion. Many states are poised to forego operating their own exchanges, and lawsuits have been filed challenging subsidies to federally run exchanges. In addition to the legal challenges that surfaced after the June 28 decision, the previous speculation leading up to the ruling, coupled with the debate during the second half of last year over how the U.S. presidential election would affect the ACA’s implementation — or potential repeal — had a major impact on health care M&A and enforcement activity.

While the Supreme Court has ruled and the elections are over, lingering factors — the ACA’s payment reforms, downward pressure on costs, enhanced focus among payers on outcomes and quality, and expanded Medicaid roles — will continue to influence M&A activity across industry sectors, increase regulatory and compliance costs, and provide additional incentives to federal and state enforcement agencies to boost enforcement efforts.

Health Care Reform Proceeds, Coupled With Uncertainty

The Supreme Court’s decision and the 2012 election clear the way for further implementation of the ACA. The following provides a timetable for key milestones of the ACA’s numerous provisions.

On or After January 1, 2013:

State and federally run health exchanges must be up and running by October 1, 2013, so individuals and businesses can purchase health insurance by January 1, 2014.

The amount of contributions to a flexible spending account for medical expenses will be limited to $2,500 per year, increased annually by the cost-of-living adjustment.

Employers who receive Medicare Part D retiree drug subsidy payments will not be able to deduct those subsidies.

An excise tax of 2.3 percent will be imposed on the sale of any taxable medical device.

The Sunshine Act will be implemented, requiring disclosures by drug, device and medical supply manufacturers of payments to teaching hospitals and physicians. The Center for Medicare & Medicaid Services (CMS) has delayed implementation, announcing in May 2012 that data collection requirements will not begin before 2013.

On or After January 1, 2014:

Funding for the Children’s Health Insurance Program (CHIP) will be extended.

A fee of $2,000 per full-time employee, excluding the first 30 employees, will be assessed on employers with more than 50 employees that do not offer coverage and have at least one full-time employee who receives a premium tax credit. Employers with more than 50 employees that offer coverage but have at least one full-time employee receiving a premium tax credit will pay the lesser of $3,000 for each employee receiving a premium credit or $2,000 for each full-time employee, excluding the first 30 employees.

The Independent Payment Advisory Board (IPAB) will submit its first annual report of legislative proposals to reduce the per capita rate of growth in Medicare spending (in the event that spending growth exceeds a target growth rate).

On or After January 1, 2016:

States will be permitted to form health care choice compacts that allow insurers to sell policies in any state participating in the compact.

An excise tax will be imposed on insurers of employer-sponsored health plans with aggregate expenses that exceed $10,200 for individual coverage and $27,500 for family coverage.

Many important aspects of the ACA’s implementation remain unclear, including how many states will elect not to operate their own exchanges, whether states will accept federal subsidies to expand Medicaid coverage, the process and criteria the IPAB will use to make recommendations to reduce health care costs, and the contours of the health care choice compacts allowing the sale of health insurance across state lines, among others.

The 934 deals worth $159.3 billion in 2012 were down from the 993 deals worth $196.5 billion in 2011 (mergermarket). Pharmaceuticals and biotechnology deals increased in the past year, but these gains were offset with declines in other major health care sectors, including medical equipment and supplies, hospitals and services.

With the Supreme Court’s ACA ruling and U.S. presidential election decided, we expect the same factors that drove M&A activity in 2010 and 2011 — compressed margins due to payment cuts, increased regulatory and compliance costs, a desire for increased exposure to high-growth markets outside the United States — to increase activity in 2013 and beyond. Financially struggling providers will seek lifelines from larger, healthier systems. Larger systems will seek to offset a decline in reimbursement rates with increased scale. Similarly, payers will continue to seek enrollment expansion through M&A. Large pharmaceutical companies likely will continue to reshuffle their business portfolios and seek new avenues for growth in emerging markets and to fill near-term gaps in their pipelines due to patent expirations and the unpredictable results of their internal R&D efforts. Small- and medium-size medical device companies will explore the need to gain scale in the U.S. and abroad in their still-fragmented sector.

Federal and State Enforcement Continues to Increase, With Ever-Larger Settlements, More Suits in the Pipeline, and Strong Incentives to Continue or Boost Prosecution

The 2012 federal fiscal year set a new record for recoveries for civil and criminal cases against health care companies. The largest settlements included the $3 billion combined criminal and civil settlement with GlaxoSmithKline over sales, marketing and pricing allegations across a range of products, and the $1.5 billion settlement with Abbott Laboratories over the marketing of a neuroscience product. GSK paid $1.5 billion to resolve False Claims Act (FCA) allegations that the company (1) promoted off-label use for the drugs Paxil, Wellbutrin, Advair, Lamictal and Zofran, and paid kickbacks to physicians to prescribe those drugs as well as the medications Imitrex, Lotronex, Flovent and Valtrex; (2) made false and misleading statements concerning the safety of the drug Avandia; and (3) reported false best prices and underpaid rebates owed under the Medicaid Drug Rebate Program.

As in past years, the primary driver of civil recoveries generally, and health care settlements specifically, was the whistleblower provisions of the False Claims Act. Of the $4.9 billion in recoveries in fiscal year 2012, a record $3.3 billion was recovered in whistleblower suits. In fiscal year 2012 alone, relators filed 647 qui tam suits. Of the nearly 8,500 qui tam suits filed since the 1986 amendments, nearly 2,200 were filed since January 2009. Looking at qui tam recoveries for the same periods, the DOJ tallied $24.2 billion since 1986, with nearly $10.5 billion of that amount recovered from January 2009 through fiscal year 2012. Since 1986, whistleblowers have been awarded nearly $4 billion, with $439 million in awards in fiscal year 2012. The vast majority of these recoveries involved health care companies.

The number of qui tam suits likely will increase in response to whistleblower-friendly amendments to the FCA. Although the DOJ has lost several significant cases in the trial and appellate courts (including the U.S. Court of Appeals for the Second Circuit’s rejection in United States v. Caronia of the government’s core theory in the prosecution of off-label promotion by drug and device makers), considering the dollars at stake, these reversals are not expected to lessen the government’s commitment to pursuing them — nor should it dampen the willingness of plaintiffs’ lawyers to pursue such cases, even when the government declines to intervene.

The continued focus on criminal and civil prosecution of health care companies makes the development and implementation of robust and comprehensive compliance programs more important than ever, with new emphasis on top-level oversight and reporting mechanisms; enhanced accountability measurers for executives and employees; compliance safeguards to ensure incentive compensation plans and performance measures do not reward improper behavior; and comprehensive monitoring and auditing plans to ensure that compliance safeguards are effective and achieve proper behavior at all levels within the organization.

Affirmative Action in Employment

The U.S. Supreme Court observed in 2003 that “major American businesses have made clear that the skills needed in today’s increasingly global marketplace can only be developed through exposure to widely diverse people, cultures, ideas, and viewpoints.”14 Indeed, 10 years later, affirmative action policies adopted by many employers are not narrowly focused on remediating the effects of past discrimination. Rather, employers increasingly are establishing policies to advance diversity, either as a social good in its own right or as a means of offering better goods and services and competing more effectively in a global marketplace. They tend to focus on expanding and targeting outreach efforts and enhancing their reputations for diversity and inclusion in their communities.

The Supreme Court has not yet squarely addressed the question of whether promoting diversity can be a sufficient justification for an employer to consider race or another protected characteristic when making employment decisions. Yet, in expanding diversity programs, many employers have been relying on guidance from the Court’s decisions on affirmative action in the higher education context. In February 2012, the Supreme Court granted certiorari in Fisher v. University of Texas at Austin, 631 F.3d 213 (5th Cir. 2011), cert. granted, 132 S. Ct. 1536 (2012), and now is poised to consider the use of racial preferences in higher education for the first time since 2003. The Court will confront issues surrounding the use of affirmative action in the name of diversity that may well influence the use of these practices by employers.

Government Contractors

Many businesses that contract with the federal government are subject to affirmative action obligations under Executive Order 11246. The executive order, enforced by the U.S. Depart­ment of Labor’s Office of Federal Contract Compliance Programs (OFCCP), requires covered federal government contractors and subcontractors to take affirmative action to ensure appli­cants and employees are treated without regard to their race, color, religion, sex or national origin.15 OFCCP regulations require each covered government contractor and subcontractor to implement a written affirmative action plan that includes an analysis identifying any underutili­zation of qualified minorities and women in its workforce and, where an underutilization is detected, sets forth placement goals, timetables for achieving a balanced workforce, and an outline of programs to achieve those goals and timetables.16 However, such goals may not include quotas, set-asides or other preferential treatment.17 The OFCCP also enforces similar affirmative action obligations pertaining to individuals with disabilities under Section 503 of the Rehabilitation Act,18 and protected veterans under the Vietnam Era Veterans’ Readjustment Assistance Act.19

Voluntary Programs

A substantial number of affirmative action programs in the United States do not fall in the government contract category and are voluntary efforts implemented by employers to further equal opportunity. Such voluntary efforts face tension with Title VII of the Civil Rights Act of 1964, which makes it illegal for covered employers to make employment decisions “because of” an individual’s race, color, religion, sex or national origin.20 In fact, the Supreme Court has construed Title VII’s prohibition against discrimination to recognize reverse discrimination claims by nonminority groups.21

In its first case to address the legality of voluntary affirmative action programs, the Supreme Court in United Steelworkers of America v. Weber, 443 U.S. 193 (1979), held that, given Congress’ clear intent in enacting Title VII to remedy discrimination against minority workers, the statute’s ban on discrimination “cannot be interpreted as an absolute prohibition against all private, voluntary, race-conscious affirmative action efforts to hasten the elimination of such vestiges.”22 Specifically, the Court ruled Title VII allows voluntary, race-conscious affirmative action plans when:

the rights of nonminority employees are “not unnecessarily trammeled” meaning the plan neither requires the termination of such employees and their replacement with minority employees, nor creates an absolute bar to advancement; and

Based on these factors, the Weber Court upheld Kaiser Steel’s program designed to eliminate racial imbalances in the company’s craft workforce by reserving half the openings in its craft-training program for black employees until the percentage of black craft-workers at the company mirrored the percentage of blacks in the local labor force.24

The Court extended Weber to cover gender-based preferences in Johnson v. Transpor­tation Agency, Santa Clara County, 480 U.S. 616 (1987), where the agency had adopted a voluntary affirmative action plan advocating that gender be used as a plus factor in employment decisions within a traditionally male-dominated skilled job classification. Looking to the criteria utilized in Weber, the Court concluded the plan did not violate Title VII because women were underrepresented in certain skilled job categories and the plan was based on aspirations rather than quotas, did not unnecessarily trammel the rights of male employees because no positions were set aside for women, and was temporary.25

Weber and Johnson make it clear that race- or gender-conscious decisions made pursuant to an appropriately tailored voluntary affirmative action plan designed to remedy the effects of discrimination in traditionally segregated job categories will not violate Title VII. However, the Court has yet to address whether a private employer’s voluntary affirmative action could be supported by a nonremedial purpose, such as a need or desire to achieve or maintain diversity in the workplace. The Court had agreed to confront this issue when it granted certiorari in Taxman v. Board of Education, 91 F.3d 1547 (3d Cir. 1996), cert. granted, 521 U.S. 1117, cert. dis­missed, 522 U.S. 1010 (1997), in which the U.S. Court of Appeals for the Third Circuit held an affirmative action plan aimed at promoting racial diversity rather than remedying the historical effects of discrimination was prohibited by Title VII. However, the Taxman case was settled before the Supreme Court answered the question.

Educational Context

Without clear direction in the employment context, cases decided by the Supreme Court in the educational context, while analyzed under the Fourteenth Amendment’s Equal Protection Clause rather than Title VII, have provided guidance for private employers considering diversity initiatives. In the landmark case of Grutter v. Bollinger, 539 U.S. 306 (2003), the Court, by a 5-4 decision, upheld the affirmative action policy used by University of Michigan Law School that considered the race or ethnicity of applicants as a “plus factor” in its individualized review of each candidate. Applying a strict scrutiny analysis under the Equal Protection Clause, the Court found that “student body diversity is a compelling state interest that can justify the use of race in university admissions,”26 and Michigan’s plan, which sought to admit a “critical mass” of minority students but did not have a specific number in mind, was narrowly tailored to serve this compelling interest.27

The Grutter decision, by focusing on societal considerations to justify affirmative action in higher education, such as breaking down racial stereotypes and preparing students for “work and citizenship” in a global economy,28 raised the question of whether these considerations may justify affirmative action in other contexts, such as employment. In fact, Justice Antonin Scalia’s dissent in Grutter cautioned on the possible extension of the majority’s reasoning to affirmative action in employment when he stated:

If it is appropriate for the University of Michigan Law School to use racial dis­crim­i­nation for the purpose of putting together a “critical mass” that will convey generic lessons in socialization and good citizenship … surely private employers cannot be criticized — indeed, should be praised — if they also “teach” good citizen­ship to their adult employees through a patriotic, all-American system of racial discrimination in hiring.29

Following Grutter, the U.S. Court of Appeals for the Seventh Circuit concluded the Court’s diversity rationale applies to hiring in public employment, ruling in Petit v. City of Chicago, 352 F.3d 1111 (7th Cir. 2003), that the Chicago Police Department “had a compelling interest in a diverse population at the rank of sergeant in order to set the proper tone in the department and to earn the trust of the community.”30 It is unclear at this point what impact Grutter and Petit may have on private employers under Title VII.

Fisher Case

On October 10, 2012, the Supreme Court heard oral arguments in Fisher v. University of Texas.31 The University of Texas at Austin follows a state mandate through which students in the top 10 percent of their high school graduating class are automatically admitted to the state university of their choice. In addition, since 2004, after Grutter was decided, the university allows race to be considered as one of several factors when admitting individuals who failed to qualify for admission under the top 10 percent rule. A nonminority Texas resident who was denied undergraduate admission to the University of Texas at Austin challenged the school’s policy under the Fourteenth Amendment’s Equal Protection Clause. She argued the policy should not have been adopted absent a “strong basis in evidence” that remedial action was necessary to address historical race discrimination by the university; the top 10 percent rule created racial diversity such that consideration of race in admission was not necessary; and the university’s consideration of race involved “racial balancing” in violation of a general prohibition against quotas.32 Relying on the Grutter precedent, the district court granted summary judgment in favor of the university33 and the U.S. Court of the Appeals for the Fifth Circuit affirmed.34

Fisher is being closely watched to see whether, given the current composition of the Supreme Court, the Court will change its position with respect to consideration of diversity in school admissions, which may provide employers with additional guidance as they consider policies and programs designed to enhance workplace diversity. The outcome of the case, which is expected in 2013, could directly impact employers in the public sector, where constitutional restrictions apply (see Global Litigation/”The US Supreme Court Term: Business Cases to Watch”). And if the Court makes a sweeping declaration that preferences based on diversity goals at universities are unconstitutional, the legality of similar private employer programs may be open to question. Such an outcome also may have implications for the permissible scope of affirmative action under executive orders, such as Executive Order 11246. Thus, the Equal Employment Advisory Council filed an amicus brief supporting neither party, urging the Court not to issue a decision that makes it more difficult for federal contractors to comply with government-mandated affirmative action requirements or impedes employers’ ability to maintain successful voluntary diversity initiatives.35

Proposed Rule

In a related development, affirmative action obligations with respect to disabled workers may be expanded drastically pursuant to a proposed OFCCP rule that would require federal contractors to strive to hire specific numbers of individuals with disabilities. On December 9, 2011, the OFCCP issued a Notice of Proposed Rulemaking (NPRM) proposing changes to Section 503 of the Rehabilitation Act, which requires that federal contractors and subcontractors take affirmative action on behalf of qualified individuals with disabilities.36 The NPRM proposes to establish a “utilization goal” of 7 percent for the employment of individuals with disabilities in each job group of a contractor’s workforce.37 The NPRM also contemplates a 2 percent sub-goal for individuals with “severe disabilities.”38

OFCCP received approximately 400 comments in response to the NPRM. Critics claim the NPRM, by explicitly looking to numbers, imposes a quota that has long been held unlawful in the race and gender context. Defenders argue that a numerical goal is good to strive for and is only just a goal. The comment period closed on February 21, 2012, and the OFCCP has not scheduled a release date for a final rule.

* * *

It will be fascinating to watch developments in this controversial area in 2013 and beyond. An affirmance in Fisher would stand as a suggestion — but not a guarantee — that nonremedial, forward-looking, diversity-based affirmative action could be viable under Title VII. However, employers considering and implementing diversity programs should proceed with caution and with full awareness that the law in this area is unsettled.

There have been a number of recent developments in tax law that may impact certain corporate tax strategies in 2013.

IRS Audits and Court Cases Reviewing Intercompany Debt

Many taxpayers have been experiencing IRS audits focusing on cross-border intercompany debt. In our experience, the potential challenges to date do not appear tightly coordinated, with theories ranging from debt-versus-equity and proper interest rates to economic substance, sham, conduit and treaty-shopping assertions. Often these disputes are resolved on audit or at IRS Appeals, but two decisions in 2012 provide new evidence of how debt/equity tax planning fares in the courthouse. The opinions reaffirm the validity of taxpayer favorable debt/equity authorities from prior decades. They make clear that tax planning is acceptable in choosing a capital structure, even when (1) that choice is informed in large part by tax considerations; (2) there is hybrid cross-border treatment; and (3) the tax planning is highly structured.

In NA General Partnership v. Commissioner,39 the U.S. Tax Court considered the characterization of cross-border inbound debt. The IRS, in claiming the notes were equity, among other points, emphasized that (1) interest payments were missed and paid late and were financed by the lender; (2) the issuer subordinated the debt to third-party borrowings that also were used to pay interest; and (3) after a few years, the debt was repaid and capitalized when it appeared U.S. withholding and foreign tax obligations on the interest payments would increase. The tax court ruled for the taxpayer and concluded that debt treatment should be respected. The court held that the issuer generally was diligent in making its payments, and that borrowing to make interest payments, including from the lender, did not defeat debt characterization. In addition to citing the court’s earlier rulings in Litton Business Systems v. Commissioner40 and Nestle Holdings, Inc. v. Commissioner,41 the court referred to Kraft Foods Co. v. Commissioner42 in reiterating that the presence of tax planning does not defeat debt characterization.

In Pepsico Puerto Rico, Inc. v. Commissioner,43 the parties’ positions were reversed, but the court’s view of tax planning was very similar. The taxpayers had issued outbound cross-border instruments that they treated as equity for U.S. tax purposes and debt for Dutch tax purposes. The instruments were long dated (40 years with a 15-year extension, becoming perpetual on default) and explicitly were repayable based only on the issuers’ financial performance. The IRS emphasized the instruments’ hybridity, focusing heavily on the taxpayers’ representations about the likelihood of repayment when seeking a Dutch tax ruling that the instruments were debt. The court was comfortable with the line drawn by the taxpayers. It noted that the instruments “were meticulously structured to ensure that annual payments [on the instruments] remained, effectively, discretionary,” but the court was not put off by the taxpayers’ planning efforts or the hybrid nature of the instruments. It stated that the taxpayers “engag[ed] in legitimate tax planning, designing the ... agreements with an expectation” of hybrid treatment. Because the other objective factors, including ability to repay and right to enforce repayment, showed that the instruments should be treated as equity for U.S. law purposes, the court respected the taxpayers’ reporting.

We expect to see continued focus on intercompany debt matters. With the recent taxpayer wins in this area, however, it may be that IRS scrutiny will turn more to appropriate interest rates than to debt/equity characterization and other theories.

The Foreign Account Tax Compliance Act Introduces New Challenges for Many

Both U.S. and international institutions continue to confront challenges and uncertainties introduced by the Foreign Account Tax Compliance Act (FATCA). Enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act in 2010, FATCA aims to prevent U.S. persons from evading U.S. taxes by holding offshore accounts. To collect information about U.S. holders, FATCA imposes sweeping new reporting and withholding obligations on foreign financial institutions (FFIs), defined broadly to include not only foreign banks, custodians and other financial institutions, but also hedge funds, private equity funds, mutual funds, insurance companies and other types of foreign entities.44 FATCA requires FFIs to enter into agreements with the IRS to report the identities and other information about their U.S. holders or face the imposition of 30 percent U.S. withholding tax on U.S. source interest, dividends and gross proceeds from sales of U.S. stocks and securities. FATCA also requires participating FFIs to withhold on certain non-U.S. source “passthru” payments made to other noncompliant FFIs. In addition, FATCA imposes new reporting obligations on nonfinancial foreign entities, which must report information on their substantial U.S. holders to paying agents to avoid the 30 percent withholding tax.

Originally scheduled to take effect in 2013, the U.S. Treasury Department and IRS have extended various deadlines and grandfathering dates to give companies more time to prepare. In addition, although the Treasury and IRS published proposed regulations in February 2012 and have issued additional guidance, many aspects of FATCA remain uncertain, including exactly what will be required of FFIs that enter into agreements with the IRS. Treasury received many comments on the proposed regulations from numerous institutions and industry groups throughout the world requesting, among other things, clarification of uncertainties, broadening of exemptions and relief from certain compliance burdens.

One hurdle to FATCA’s implementation has been local bank secrecy laws, which may prevent disclosure of information required by FATCA. Over the past few months, the U.S. has been negotiating intergovernmental agreements with other countries that address the hurdle by allowing institutions in those countries to report information to their local jurisdictions’ tax authorities instead of to the IRS, along with reciprocal information access privileges in the United States. The agreements also offer greater clarity, in certain cases, by providing a list of deemed compliant local institutions for a particular country.

FATCA will affect a wide range of transactions and market participants. In capital market transactions, U.S. issuers potentially will have to perform withholding on interest, dividends and gross proceeds if foreign institutions do not provide the required information. Further, FATCA may apply to stock or securities issued by non-U.S. companies under the “passthru payment” provisions if the issuers are considered to be FFIs.45

In credit agreements and other financings, lenders and borrowers must allocate the risk of FATCA withholding among the parties. While lenders in U.S. markets typically have accepted the FATCA risk to date, this has not necessarily been the case in European and other non-U.S. markets. Likewise, swaps and other derivatives involving foreign parties implicate FATCA withholding, the risk of which has been allocated to the payer in recent transactions.

Finally, institutions that may be considered FFIs, including hedge funds and other investment vehicles, must prepare for the new compliance and reporting requirements in the face of significant uncertainties. Many funds already have taken steps to amend their governing documents and subscription agreements to incorporate provisions designed to address reporting requirements and the imposition of potential withholding tax if an investor fails to comply. Increasingly, foreign investors in investment funds that may have exempt status (such as sovereign entities) are seeking to address FATCA through side letters with the funds.

The Treasury and IRS expect to finalize the FATCA regulations soon. Moreover, we expect to see more intergovernmental agreements in the coming months. The final regulations likely will integrate the structure of the intergovernmental agreements and respond to some of the significant comments received.

Headline Risk — New Challenges for Corporate Tax

As public attention to fiscal issues has increased worldwide, so has interest in multinational corporations’ direct tax contributions as a proportion of their global operating income. Executive and legislative bodies not normally focused on international tax issues have conducted inquiries into multinational companies’ tax affairs and summoned senior executives to testify on the subject. At the same time, media attention and public lobbying surrounding corporate taxes have increased.

In connection with this heightened interest in multinational tax planning, aggressive political inquiries and superficial media coverage can bring undesirable and unwarranted attention to a few companies targeted by government investigations or news stories. For example, U.S. senators have been quoted in The Wall Street Journal and Bloomberg Businessweek as referring to cross-jurisdictional transfer pricing rules as “gimmicks,” “shenanigans” and “an unbelievable scandal.” In the U.K., a Parliamentary committee held a hearing during which multinational technology companies and retailers were accused of “immorality.” With statements like these, it is clear that corporate tax has become a frontline corporate social responsibility issue for multinationals on both sides of the Atlantic, as well as a particular vulnerability for B2C businesses’ revenue lines.

What it is all about. For most corporate groups, the effective tax rate on net operating income is essentially a function of where income is earned and how it is financed (tax base) and the tax imposed on that income (tax rate). Therefore, relevant to this calculation are:

asset ownership — where a group owns, develops and invests in its most important income generating assets; and

corporate finance — how a group raises capital and deploys operating cash flow.

Most governmental and press attention to corporate tax has focused on the perceived disparity between where customer revenue initially is earned and where the associated income is taxed. The public inquiry questions why a corporate group that reports a large amount of revenue in the U.S. or the U.K. does not pay direct corporate tax in proportion to the revenue earned in that country.

The fundamental misconception underlying this inquiry is an assumption that one can allocate net income to a jurisdiction based on a group’s gross revenues and a uniform profitability ratio that ignores the specific mechanism of the group’s supply chain, financial structure and other aspects of its operating model. Put differently, some jurisdictions house profit centers and others house cost centers. Although the deductions available in a cost center jurisdiction can reduce taxable income, cost center jurisdictions can nevertheless collect significant amounts of tax from the group, e.g., through payroll taxes, local business and real estate taxes, and supply taxes, such as value-added taxes (VAT).

Despite the suggestions of some governmental agencies and the press, tax outcomes tend to follow the facts. It is difficult to manipulate the operation of these rules, and multinationals regularly face inefficient tax outcomes due to the actual business processes that exist in various jurisdictions. Genuine substance and functionality are respected and taxed in a range of high-rate and low-rate jurisdictions as a result.

What it means for corporate groups. Government inquiries and press attention, and the underlying fiscal principles that prompt them, are largely outside of the control of most groups. However, sound preparation and organizational communication, as well as intelligent liaison with relevant fiscal and governmental bodies, can allow companies to manage the reputational consequences of such inquiries and coverage and avoid surprises. While the specifics of this vary by company and industry, some best practices include:

Consider carefully the impact of any agreements with tax authorities on worldwide tax positions. While some companies appear willing to adjust their transfer pricing in response to these inquiries, such adjustments may have unforeseen consequences for positions taken in other jurisdictions and with respect to credits for foreign taxes paid.

Ensure that key commercial, finance and legal teams understand the group’s tax and transfer pricing structure. This reduces the risk of less informed responses to press and governmental inquiries and heightens awareness of the need for coordinated responses.

Position the internal tax function to report to the board on the potential public relations impact of tax strategy as part of its overall reporting mandate and seriously consider the public relations risk in selecting appropriate tax strategies.

Seek to control leaks and maintain confidentiality on sensitive tax strategy discussions and outcomes, particularly while they are in the gestation phase.

Be prepared with a current synopsis of total fiscal contribution to key jurisdictions, highlighting payroll taxes administered at source, VAT and other supply taxes, stamp duties and transfer taxes, local business taxes and rates, and direct corporate taxes and withholding taxes. A “contribution statement” such as this illustrates the overall contribution of a corporate group to the local society it services. Get it right the first time — retracting or adjusting the statement, as has happened before, worsens public impression of the issues.

Prepare economic arguments to illustrate reasons for low effective tax rates on apparently high revenues (e.g., costs of growth, completion in the local market, high employer costs of adding to the payroll, etc.).

Send the right person (e.g., the CTO, CFO or CEO rather than a press officer or public relations expert) to field sensitive inquiries so that technical answers are available to difficult questions.

Corporate Tax Reform: Prospects for Fundamental Change

Tax policy at the end of 2012, consumed as it was with the fiscal cliff, was focused on fixes to the individual income tax system. In contrast, in 2013 we may see the focus shift to fundamental tax reform, including proposals that would bring significant change to the corporate tax system.

Two major corporate tax reform proposals — with varying levels of detail — have been issued in the past year and a half: the President’s Framework for Business Tax Reform, released in February 2012 (the President’s Proposal), and House Ways & Means Committee Chairman Dave Camp’s (R–MI) International Tax Reform Discussion Draft, released in October 2011 (the Camp Discussion Draft). While differing in their approach, the proposals share certain commonalities that provide the outlines of any likely corporate tax reform, including reduced corporate tax rates, a broadened corporate tax base and fundamental changes to the taxation of foreign income.

President’s Proposal. The President’s Proposal would reduce the corporate tax rate to 28 percent from the current 35 percent rate and expand the corporate tax base to compensate for the lost revenue. The proposal identifies a number of tax “loopholes” and “expenditures” that it says should be eliminated, including LIFO accounting, “preferences” for the oil and gas industry and insurance products, and preferential depreciation for corporate aircraft. Perhaps recognizing that these items would raise insufficient revenue to achieve the targeted rate reduction, the proposal includes a menu of other base-broadening options that it says should be considered. These other options include far more sweeping changes to the taxation of business income, including limiting the deductibility of interest on indebtedness, lengthening depreciation schedules, altering the tax status of large pass-through entities such as large partnerships and S corporations, and taxing carried interests as ordinary income.

While the President’s Proposal generally attempts to expand the corporate tax base to finance the reduced tax rate, it contains a number of proposals that would provide preferential treatment for manufacturing activities, such as (1) expanding the domestic production activities deduction to lower the effective tax rate on domestic manufacturing income to 25 percent, with a lower rate on “advanced” manufacturing income; (2) expanding and making permanent the simplified R&D credit; and (3) extending and making permanent various tax incentives for the development of clean energy.

The President’s Proposal also contains significant changes to the taxation of foreign income, many of which also have been included in the president’s annual budget proposals. The President’s Proposal would limit substantially the deferral of taxation on foreign income by (1) imposing a minimum tax, at a currently unspecified rate, on all low-taxed foreign income, (2) subjecting to current U.S. taxation any “excess returns” earned on intangible property shifted from the U.S. to a foreign jurisdiction, and (3) deferring the deductibility of interest expense that is allocable to foreign income until such income is repatriated.

Camp Discussion Draft. In contrast to the President’s Proposal, the Camp Discussion Draft focuses almost exclusively on international tax reform. The Camp Discussion Draft proposes a reduced corporate tax rate of 25 percent but leaves the details regarding the base broadeners necessary to finance that reduced rate for future consideration.

On the international tax side, the Camp Discussion Draft would replace the current worldwide taxation system with a largely territorial tax system under which dividends received by U.S. corporations from their foreign affiliates would be 95 percent exempt from U.S. tax. Whereas under current law, foreign earnings are subject to full U.S. taxation upon repatriation, with a credit for foreign taxes paid, under the Camp Discussion Draft, foreign earnings would be subject to an effective U.S. tax rate of 1.25 percent upon repatriation. The Camp proposal also would impose a transition tax on pre-reform accumulated unrepatriated earnings, which would be subject to current taxation at a 5.25 percent rate, with the tax payable in installments over eight years. The transition tax on accumulated income, together with the exemption for future foreign earnings, would greatly diminish, if not eliminate, the lockout effect that causes many U.S. multinational corporations to accumulate earnings abroad, lest they face full U.S. taxation at a 35 percent rate upon repatriation of those foreign earnings.

The Camp Discussion Draft also includes three “base-erosion” proposals that would subject certain types of foreign income to full, current U.S. taxation. These proposals are designed to limit the incentive that domestic corporations otherwise may have to shift income offshore under a territorial system in which that income would be permanently exempt from U.S. taxation.

Option A would tax excess returns earned on intangible property in a manner similar to the president’s excess-returns proposal.

Option B generally would subject to full U.S. taxation any foreign income subject to an effective foreign tax rate less than 10 percent, with an exception for income earned in the foreign affiliate’s home country.

Under Option C (which we understand Chairman Camp currently favors), foreign income earned on intangible property exploited within the U.S. (i.e., income on foreign affiliate sales to the United States) would be subject to full U.S. taxation; foreign income earned on intangible property exploited outside the U.S. (i.e., income on foreign-to-foreign sales) would be subject to a reduced 15 percent rate of taxation, as would income earned by a domestic corporation from the foreign exploitation of intangible property (i.e., income on export sales).

These base-erosion proposals are suggested as potential alternative options with input requested from the public regarding their design.

Finally, the Camp Discussion Draft includes a “thin-capitalization” proposal that would limit the deductibility of interest by a domestic corporation if, and to the extent that (1) the U.S. members of the corporate group are over-leveraged as compared to the worldwide corporate group and (2) interest expense exceeds a certain — as yet unspecified — percentage of adjusted taxable income (taxable income before interest, depreciation, amortization and other specified expenses).

Outlook

Though the President’s Proposal and the Camp Discussion Draft differ fundamentally in many respects, there is a potential path toward compromise on corporate tax reform. For example, agreement might be reached on a reduced tax rate around 28 percent, paid for with base broadeners, together with a territorial system that generally exempts foreign income from U.S. taxation but that (1) taxes foreign affiliates’ intangible income on sales to the U.S. (as under Camp’s Option C), and (2) imposes a minimum tax between 10 percent and 15 percent on all other foreign income (thereby combining the president’s minimum tax with Camp’s Option B). Such a compromise likely would have significantly differing impacts on multinational corporations depending on their tax and business profiles, making it unlikely that the business community would reach a consensus in support of such a proposal.

Ultimately, the timing and precise contours of corporate tax reform remain highly uncertain, but the prospects for corporate tax reform remain higher now than at any time in the recent past, and such reforms — whether changes to rates, the tax base or the taxation of foreign income — likely will have a significant impact on corporate taxation in the United States.

44 The definition currently is so broad that it potentially could capture certain foreign holding companies that are not engaged primarily in a financial business.

45 Given significant uncertainty surrounding the breadth of the “foreign financial institution” and “passthru payment” definitions, the Treasury and IRS recently issued a notice extending the grandfathering date for obligations that would be subject to “passthru payment” withholding.

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